July 4 Stock Picks: Screening for Strong Representatives of American Industry

by: Erik Dellith

In honor of upcoming Independence Day, I want to focus on strong representatives of good ol’ American industry, the backbone of the US economy. Here’s how we could create such a screen.

Since we want to highlight manufacturing-type firms, we start by focusing on companies in the capital goods sector. Further, we want to include members of the auto industry, such as the auto & truck manufacturers, as well as the tires and auto parts companies, so we include companies in the consumer cyclicals sector. Because the basic materials companies consist of chemicals, plastics, and packaging manufacturing, we include this sector as well. Technology is an important driver of the modern world. Although some services are found in this sector, this segment of the market also consists of companies that make computer hardware, electronic instruments, and semiconductors. As such, we include this group, too.

It is tempting to include the transportation sector, but because the focus is more on manufacturing, we exclude those as well. The energy and utility sectors are a difficult call, but we can omit them, too. We avoid financials, consumer non-cyclicals, healthcare, and services.

Running the screen on Friday returns 2,989 companies in the highlighted sectors. The next part is to focus on the “strong” representatives.

There are many different ways to define “strong”. Strength is, after all, a relative state. In order for something to be strong, something else has to be relative weaker. We filter out the weaker companies by writing a screen that requires companies to be stronger or better than their peers.

An easy place to start is revenue and earnings growth. As such, we require that a company’s revenue and EPS growth rates in the trailing twelve-month (TTM) period must be faster the median for its industry. That relatively simple filter greatly reduces our list of names to 736.

Just because a company’s EPS is growing faster than the industry midpoint doesn’t necessarily tell us why it is faster, and the reason matters. It is one thing if earnings are barely growing and the company initiated an aggressive stock repurchase plan in an attempt to beef up EPS. It is quite another if the growth in earnings is because margins have widened and that has allowed more of that superior top-line improvement to make its way to the bottom line. For this reason, we screen for companies that have operating margins greater than the industry median. We take this a step further to focus on improvement and require that the latest annual operating margin must be at least 10% greater than the previous year’s operating margin, and that figure must be at least 10% greater than the reading from two years ago. This leaves us with 143 names.

The importance of liquidity cannot be overstated. We turn our attention next to measures of liquidity, which tell us about the firm’s ability to meet its short-term obligations. If business conditions turn sour, inventory may not get sold, so we focus on the Quick Ratio (Acid Test) instead of the Current Ratio. We require that a company’s Quick Ratio be higher than the industry median. This reduces our list of companies to 74.

Of course valuation also needs to be considered. While good companies often command premiums, we want to focus on some potential investment opportunities, so we look for stocks that are relatively cheap. To accomplish this, we focus first on stocks with P/E ratios (based on TTM EPS) that are less than the industry median. How much less? That depends on your personal tastes, but we set the bar at 80% of the industry reading for this exercise.

We also take into consideration analyst expectations of future earnings for this year and next. We require that the forward P/E ratios be less than the industry norms. Still, some industries could be richly valued on the basis of expected EPS, so it is not enough for us to require stocks with relatively lower P/E ratios. We also use the PEG ratio. Although there is no hard and fast rule about what constitutes a reasonable price tag with the PEG ratio, we require that it be less than 1.5.

Let’s not forget what gave us this idea: America’s birthday. So, we will filter out countries that are not domiciled in the USA.

As of Friday afternoon, our resulting list consists of 15 names, for further review. Here is the list:

  • Arrow Electronics, Inc. (NYSE:ARW)
  • Cirrus Logic, Inc. (NASDAQ:CRUS)
  • DDi Corp. (NASDAQ:DDIC)
  • Entegris, Inc. (NASDAQ:ENTG)
  • Entropic Communications, Inc. (NASDAQ:ENTR)
  • Finisar Corporation (NASDAQ:FNSR)
  • G-III Apparel Group, Ltd. (NASDAQ:GIII)
  • Great Lakes Dredge & Dock Corp. (NASDAQ:GLDD)
  • KEMET Corporation (NYSE:KEM)
  • Nanometrics Incorporated (NASDAQ:NANO)
  • NACCO Industries, Inc. (NYSE:NC)
  • Novellus Systems, Inc. (NASDAQ:NVLS-OLD)
  • Rudolph Technologies, Inc. (NASDAQ:RTEC)
  • SanDisk Corporation (SNDK)
  • Teradyne, Inc. (NYSE:TER)

Happy Independence Day.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.